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Schroders warns of the risks of foregoing inflation protection in retirement

Schroders has created a list of questions to help defined contribution (DC) members consider how to protect themselves against inflation.

02/10/2013

Schroders has created a list of questions to help defined contribution (DC) members consider how to protect themselves against inflation. According to a UK Parliamentary study1, around 95% of individuals are foregoing inflation protection for their retirement income by opting for fixed rather than inflation-linked annuities. This leaves them open to the risk of rising inflation eroding their income in retirement.

Mark Humphreys, Head of UK Strategic Solutions, Schroders comments:

“The lack of options available for DC members seeking a reasonable level of inflation-protected retirement income highlights the need for the development of new products and solutions designed to see retirees comfortably through their old age.

“A substantial rise in inflation would mean that DC members who have opted for fixed rather than inflation-linked annuities could see a severe erosion of their retirement benefits. We have created these inflation questions specifically for DC members to help them consider how to manage inflation risk, and what they should be focusing on.”

1. Why do pensioners need inflation protection and how likely is an inflation rise?

A rise in inflation would erode the real value of a fixed rate annuity, as living costs would rise, while the fixed annuity income would remain the same. The past two decades have seen declining and low inflation in the UK, and many people find it hard to envisage a return to a higher inflation environment like that of the 70s and early 80s. However, there are a number of factors which could drive a rise in inflation in the medium term, and the consequences of this for fixed annuity holders could be severe.

1.1. High and Rising Debt At the end of Q1 2013, UK government debt was 88% of GDP.

This debt burden is forecast to increase, and the European Commission expects gross UK government debt to surpass 98% of GDP by 2015. With the UK government struggling to tackle the debt problem, we would suggest that an extended period of high inflation may well get the debt problem under control.

1.2. The Bank of England is focusing on growth rather than inflation

Recent years have seen the Bank of England placing a strong emphasis on encouraging economic growth, with extreme measures being taken to encourage lending and consumption. Since March 2009, the Monetary Policy Committee has authorised £375 billion of asset purchases through the Quantitative Easing Programme, while interest rates have held constant at an historical low of 0.5%2 .

On his appointment in March 2013, new governor of the Bank of England Mark Carney was given the mandate to stimulate economic growth in the UK. The Bank’s recent decisions to maintain its ultra-loose monetary policy despite growing and above-target inflation levels are evidence of the Bank’s focus on stimulating growth over controlling inflation.

2. Why are DC members forgoing inflation protection when selecting an annuity?

There are a number of behavioural biases that could be responsible for an individual’s decision to forgo inflation protection in their annuity purchase. These include a preference for present rather than future consumption, and recency bias, which means placing too much weight on the recent past when building expectations for the future.

3. So, should members be purchasing inflation-linked annuities?

While the tendency of DC members to overlook inflation protection in their annuity purchase decisions may be largely due to behavioural biases, it does not necessarily follow that inflation linked annuities are a better option than fixed annuities.

The payback period is the simplest way to judge the relative worth of index-linked and fixed annuities. This is the length of time it would take for the cumulative value of inflation-linked annuity payments to exceed that of the fixed annuity payment.

In our modelling, the ‘payback period’ of inflation-linked annuities exceeded the expected lifespan of our example member unless inflation was above 5% (significantly higher than market estimates of breakeven inflation of 3.6% over the same period) 3 .

On average, a 65 year old man is currently expected to live until 834 , so the expected time horizon over which an annuity will be paid is 18 years. At 19 September 2013, breakeven inflation5 over 18 years is 3.6%6 . With inflation at this level, the model shows that it would take around 26 years for the value of the index-linked annuity to reach that of the fixed annuity – far exceeding the life expectancy of our annuity purchaser.

This means that, unless inflation is much higher than expected, it is cheaper to purchase a fixed annuity than one with inflation protection.

Another point to consider is that many DC members have other sources of income that do provide inflation protection. For example, many have accrued some years towards a “final salary” pension, and lower income members will rely on a state pension for a significant portion of their retirement income. Members who expect to receive a significant portion of inflation-linked retirement income from other sources typically have less need to purchase an inflation-linked annuity.

4. What happens if you delay (or avoid) annuitisation?

Rather than purchasing an annuity with their pension pot at the point of retirement, members have the option to keep their savings invested in a fund and draw income from it over time. The amount pensioners can draw down each year is subject to a cap level set by the government. There is no cap for pensioners with an annual income of at least £20,000 a year.

Whilst this option increases flexibility for members by providing an alternative to annuitisation, there is still a risk that the income it provides may not keep up with inflation if the investments in the fund achieve lower than expected returns. This option also introduces an additional risk that the member lives longer than expected and exhausts their savings.

5. How can the pensions industry help?

The lack of options available for DC members seeking a reasonable level of inflation-protected retirement income highlights the need for the development of new products and solutions designed to see retirees comfortably through their old age. We believe the pension industry can certainly help with this.

Schroders UK Strategic Solutions team studies the key risks involved with pensions and how these can be mitigated. To view further thought pieces from the team visit http://www.schroders.com/ukpensions/home/

1 From a UK parliamentary publication on Quantitative Easing, November 2012

2 Bank of England website

3 Based on annuity rates at 20 September 2013 (from Annuity Direct) and 18 year breakeven inflation at 19 September 2013 (from the Bank of England implied inflation curve)

4 Based on a 65 year old man living in England. ONS (2013).

5 Breakeven inflation is a measure of market expectations of the average inflation over a given time frame